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Group 1 Automotive (NYSE:GPI) Use Of Debt Could Be Considered Risky

Simply Wall St

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Group 1 Automotive, Inc. (NYSE:GPI) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Group 1 Automotive

What Is Group 1 Automotive's Net Debt?

The chart below, which you can click on for greater detail, shows that Group 1 Automotive had US$2.88b in debt in June 2019; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.

NYSE:GPI Historical Debt, October 17th 2019

A Look At Group 1 Automotive's Liabilities

The latest balance sheet data shows that Group 1 Automotive had liabilities of US$2.34b due within a year, and liabilities of US$1.73b falling due after that. Offsetting this, it had US$37.7m in cash and US$208.8m in receivables that were due within 12 months. So its liabilities total US$3.82b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the US$1.62b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we definitely think shareholders need to watch this one closely. At the end of the day, Group 1 Automotive would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 6.2, it's fair to say Group 1 Automotive does have a significant amount of debt. However, its interest coverage of 2.8 is reasonably strong, which is a good sign. More concerning, Group 1 Automotive saw its EBIT drop by 2.7% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Group 1 Automotive's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Group 1 Automotive produced sturdy free cash flow equating to 54% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Group 1 Automotive's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that Group 1 Automotive's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Given our concerns about Group 1 Automotive's debt levels, it seems only prudent to check if insiders have been ditching the stock.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.